CONVENTIONAL WISDOM/CONTRARIAN OPTIONS - Weekly Blog # 605

Mike Lipper’s Monday Morning Musings

CONVENTIONAL WISDOM/CONTRARIAN OPTIONS

Editors: Frank Harrison 1997-2018, Hylton Phillips-Page 2018 –

At all times investors have strategic choices, they can choose to ride current momentum trends or opt for one or more counter/contrarian trends. Unless investors are extremely disciplined, most portfolios reflect a combination of both extremes. Nevertheless, when investors consider the likely track of their choices, it is a good time to consider the proportion of their financial responsibilities allocated to the momentum or contrarian extreme. I find it useful to go through this thought pattern periodically, either at recognized peaks/troughs or some calendar driven date. Due to the US market officially trading only three and a half days this week, it gave me time to ponder the future.

We appear to be within a current momentum trend of rising stock prices, which has historically produced relatively small future gains. Consequently, there is added interest in examining contrarian options. Contrarian alternative investment performance will likely bifurcate, with some producing outsized gains as they become eventual momentum vehicles. Their returns will likely be much larger than the mid-level opportunities facing conventional wisdom now. On the other hand, some contrarian options will fail and decline, or more likely produce rather flat or underperforming returns.

The following divides the evidence that favors momentum or leans toward my natural search for contrarian points of view:

Conventional Wisdom:

1. “The trend is your friend” is an old saying which celebrates the power of momentum, which lasts until it doesn’t. The terminal phase of a trend can either slowly peter out or come to an abrupt stop. Sometimes a new trend immediately supersedes a tiring one or is replaced by a trendless market. Some date the beginning of the current trend to 2009, while others date it to December 2018. Regardless, the information technology driven market trend continues to lead indices higher.
2. Tied to the first point, the level of reigning pundit conviction is the fuel driving the engine and that is prolonging the trend. There are no publicly anointed “bears”.
3. In aggregate, because long-term oriented equity mutual funds have liquid assets that approximate their current level of monthly net redemptions, there is reduced potential for a redemption-led sudden market decline.
4. As of the end of this week there are five equity investment objectives that have generated average year-to-date gains of over 30%.

Contrarian Points:

1. In the US and in most countries, the amount of money invested in bonds dwarfs the amount in stocks. If bonds are purchased at the offering and held to maturity there is very little opportunity for price appreciation. Bond investors therefore tend to be more cautious than stock investors, who believe in the chance of earning more than their purchase cost. The two markets are interlocked in that economies and companies typically need fixed income investments to provide the financial leverage necessary for equity owners to earn overall economic returns above those of their companies. Bond owners prefer little to no risk, whereas stock owners are willing to accept risk if it is appropriately priced. Due to this dichotomy, the spread between stock and bond returns is viewed as an important measure of market value. The 5-year average return gap, +6.07% for equity funds vs. +2.75% for domestic bond funds, is too wide. For the current year the gap is even wider, +21.05% for stock funds vs. +7.81% for domestic taxable bond funds. A related concern is the drying up liquidity reserves for global central banks at the US Federal Reserve. Historically, a contraction of liquidity reserves has often led to dramatic disruptions in the fixed income markets. If the cost and availability of leverage goes up suddenly, it could hurt stock markets.
2. US stock market indices appears to be confused. The price chart for the Dow Jones Industrial Average and the S&P 500 Index are forming a topping pattern. However, this past week there were 56  new lows on the New York Stock Exchange vs. 136 on the NASDAQ. (The two markets have roughly the same number of traded issues.) What makes this a bit confusing is the NASDAQ market has risen more than the NYSE and its chart pattern is not yet in a topping formation. Many market professionals believe you need high transaction volume to confirm any important move. We are not seeing that now, either in the number of shares traded or in price volatility. In terms of the latter, the VIX volatility indicator is currently running at 12.55 vs. 18.07 a year ago in the sagging fourth quarter. Bottom line, while there are some bearish signals, we need to see some form of confirmation before we hoist the “bear” flag.
3. One of the lessons I learned from a very successful mutual fund executive, now no longer with us, is that markets move on the weight of money. What this means is that a small fund of $1 million performing spectacularly well  is much less important than a fund management company of $50 billion increasing by $5 billion due to performance or net sales. Thus, I am more influenced by the $20 trillion in taxable long-term mutual funds than market indices. My old firm prepares the performance of the 25 largest long-term mutual funds for The Wall Street Journal weekend edition. Only three have gains of over 25% vs. the 25.68% year-to date gain for the US Diversified Equity funds average. Six income-oriented funds produced returns of under 10%. Despite what many regulators, media, and financial educators believe, this shows that owners of mutual funds may be attracted to performance, among other values. Most of all, they value the comfort and trust in their own and their advisers’ decisions. Communication skills are important to breed the confidence that their investments will be taken care of during periodic market declines. That they will have the funds available when there is the need for orderly redemptions. This applies to both stock and income-oriented funds. The six income-oriented funds that produced mid-single digit returns all generated performance that fell below the average of seven different fixed-income fund objectives. Obviously the owners of these funds, like many of their equity fund compatriots, are not primarily interested in relative performance.
4. The Wall Street Journal had an article titled “Stocks Projected to Slow”, stated by some portfolio managers and others looking at 2020 performance. In the article, some expected earnings gains of 3%, while others expected the economy to grow at roughly the same amount, with profit-margins maintained. Considering valuations, measured by reported earnings and price/earnings ratios, next year doesn’t look to be a great performance year. 

If you share these views I suggest potential returns are not adequate to cover the chance of negative surprises, particularly at the operating earnings level. If Charlie Munger and Warren Buffet can show patience to invest their $128 billion of Berkshire Hathaway’s (*) available cash at their age, maybe you can too.

(* Owned in a managed private financial services fund and personal accounts.)

Question of the week: 
Do you spend all your investment time selecting individual investments or do allocate some time to evaluate the structure of your portfolios and risks?


Did you miss my past few blogs? Click one of the links below to read.
https://mikelipper.blogspot.com/2019/11/contrarian-stock-and-bond-fund-choices.html

https://mikelipper.blogspot.com/2019/11/mike-lippers-monday-morning-musings-all.html

https://mikelipper.blogspot.com/2019/11/where-are-we-and-so-weekly-blog-602.html



Did someone forward you this blog?
To receive Mike Lipper’s Blog each Monday morning, please subscribe by emailing me directly at AML@Lipperadvising.com

Copyright © 2008 - 2019
A. Michael Lipper, CFA

All rights reserved
Contact author for limited redistribution permission.